New capital gains tax rate: Custodians face dilemma over FPI withholding tax

The Budget, presented on July 23, raised Long-Term Capital Gains tax rate from 10 percent to 12.5 percent and Short-Term Capital Gains from 15 percent to 20 percent.

India’s leading custodian banks are facing a dilemma over how much tax to withhold from Foreign Portfolio Investors(FPIs) following the budget announcement increasing capital gains tax rate.

Presenting the FY25 Budget on July 23, finance minister Nirmala Sitharaman said the Long-Term Capital Gains (LTCG) tax rate was being raised from 10 percent to 12.5 percent and Short-Term Capital Gains (STCG) from 15 percent to 20 percent for listed equities. The new rates would kick in from July 23, the minister said.

Unlike residents who pay capital gains tax while filing annual returns, FPIs pay on a trade-to-trade basis and custodians are entrusted with the responsibility of withholding the tax.

However, several FPIs, following tax consultants’ opinions, are taking a view that the increase is still a proposal and doesn’t become a law till the Budget is passed by both houses of Parliament and gets the President’s approval. Hence, they are of the view that old rates should continue to apply, for now.

The FPIs’ aggressive stance has put custodians in a spot since they have the fiduciary responsibility under the law to deduct the right amount of tax and the tax department can come after them in case of a short fall.

“Since the budget proposals technically could change when passed in Parliament, the revision in tax rates is not considered as enacted for tax and other purposes,” said Rajesh Gandhi, partner, Deloitte.

A few FPIs are also in the process of winding up their funds in India. They are also facing challenges in determining their tax liability. The problem for such funds is that if they distribute the proceeds among investors right now, they are not sure if the old or the new rates will apply.

“Some of the FPI are also facing a dilemma on when to accrue the extra tax. Funds that are closing in the interim have to keep extra tax because, once paid to the investors, they will never be able to recover it back and may face a shortfall in taxes,” said Suresh Swamy, partner, PriceWaterhouse & Co LLP. “Indian revenue should consider applying the increase in taxes prospectively rather than retroactively.”

The tax regime for FPIs is designed to ensure that offshore funds that have no presence in India pay the full amount of taxes as applicable.

In the case of residents or domestic funds, if a shortfall is noticed during annual filings, the tax department can recover the unpaid dues using its various enforcement powers. The process becomes tricky for offshore funds, as they have no presence in India and may not even have any local assets.

There have been instances where entities mandated to withhold tax faced action by the tax department for collecting lower than specified taxes.

One famous example is the retrospective tax case of Cairn Energy where the Indian entity Vedanta was required to withhold tax on the stake sale by Cairn. However, there was a serious shortfall in the withholding tax, prompting the tax department to go after Vedanta for not fulfilling its obligation. The Centre eventually settled the dispute with Cairn along with similar cases including the Vodafone case.